The rapid spread of digitalisation has driven considerable changes in the way businesses operate. This has led to the emergence of new business models and to the substantial transformation of old ones. These changes have placed pressure on the basic concepts underlying the existing international tax rules, which were created almost a century ago.

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The 2015 OECD’s Base Erosion and Profit Shifting (BEPS) package produced a substantial renovation of the international tax rules, underpinned by the principle that the location of taxable profits should be aligned with the location where economic activities and value creation take place.

The question, however, remained on whether the package adequately addressed the broader tax challenges regarding nexus, data, and characterisation raised by the digitalisation of the economy. These challenges go beyond the issue of how to put an end to BEPS and chiefly relate to the question of how taxing rights on income generated from cross-border activities in the digital age should be allocated among countries.

On October 12, 2020, the OECD released the report on the Pillar One Blueprint the blueprint which seeks to address tax challenges arising from digitalisation. The aim of Pillar One is to reach a global agreement on changing the allocation of taxing rights on business profits in a way that expands the taxing rights of market jurisdictions. In order to achieve this, Pillar One contains three elements:

New taxing rights for market jurisdictions over a share of the residual profits of a multi-national enterprises group (MNE) or segment of such a group.

A fixed return for certain baseline marketing and distribution activities taking place physically in a market jurisdiction.

Processes to improve tax certainty through effective dispute prevention and resolution mechanisms.

Eleven building blocks that are considered essential to the construction of Pillar One are described in the Blueprint. These proposals mark a significant policy shift in international taxation.

It is acknowledged that the Blueprint does not reflect agreement by the member jurisdictions of the Inclusive Framework on BEPS because there are political and technical issues that still need to be resolved. However, the Blueprint is a "solid basis for future agreement” and states that the member jurisdictions have agreed to keep working “to swiftly address the remaining issues with a view to bringing the process to a successful conclusion by mid-2021.

The proposals under Pillar One represent a substantial change to the tax architecture and go well beyond digital businesses or digital business models. These proposals could lead to significant changes to the overall international tax rules under which businesses operate.

Taxation of the digital economy raises complex technical questions, and there are also differing views among countries on the extent of changes to the international tax rules. The digitalisation of the economy does raise questions regarding the relevance and effectiveness of some key concepts underlying the existing international tax rules, namely nexus and profit allocation rules, which are strongly rooted in physical presence requirements.

The principal focus of the existing tax framework has been to align the distribution of taxing rights with the location of the economic activities undertaken by the enterprise including the people and property that it employs in that activity. This conceptual approach was recently reinforced by the BEPS project, which sought to realign the location where profits are taxed with the location where economic activities take place and value is created. However, the effectiveness of these rules may be challenged by the digitalisation of the economy to the extent that value creation is becoming less dependent on the physical presence of people or property.

Concerns about the inadequacy of the current rules to deal with the broader tax challenges is evidenced by the increasing number of uncoordinated, unilateral actions taken since 2015. Hence, it is important to find a multi-lateral solution to the issues, taking into account the perspectives of all stakeholders. Since 2016, India has introduced a number of unilateral measures to address tax challenges arising from digitalization. These measures range from the introduction of an equalization levy on certain digital transactions to bringing in the concept of significant economic presence as a basis for taxable nexus under the domestic tax law. These unilateral measures are likely to create challenges for multi-national businesses and hamper digital transformation. Hence, it is important to bring this process to a successful conclusion within the stated timelines so that jurisdictions can implement a consensus-based solution.

(Rajendra Nayak, Tax Partner and National Leader, International Tax Services, EY India)

(Views expressed are personal)

(Edited by : Jomy)